2008 (7) TMI 442 - AT - Income Tax

Profit on sale of shares - conversion of the stock-in-trade into investments - difference between the sale price of the shares and the cost of acquisition of share - CIT(A) directed the AO to treat the profit on sale of shares under the head 'Long-term capital gain' - HELD THAT - We find that the shares held in stock-in-trade were converted into investment at the book value shown in the books of account. Later on, the shares held in investment were sold and the assessee offered the capital gain accrued on the sale of shares. Admittedly, the provisions of s. 45(2) of the IT Act, deals with the issue of capital gain where the investment is converted into stock-in-trade. We are also conscious about the judgments in the cases of Sir Kikabhai Premchand 1953 (10) TMI 5 - SUPREME COURT and Dhanuka Sons 1978 (7) TMI 22 - CALCUTTA HIGH COURT in which it has been held that there cannot be an actual profit or loss of such transfer when no third party is involved and the items are kept in a different account of the assessee himself. In the absence of a specific provision to deal with the present situation, two formulae can be evolved to work out the profits and gains on transfer of the assets. One formula which has been adopted by the AO i.e., difference between the book value of the shares and the market value of the shares on the date of conversion should be taken as a business income and the difference between the sale price of the shares and the market value of the shares on the date of conversion, be taken as a capital gain. The other formula which is adopted by the assessees i.e., the difference between the sale price of the shares and the cost of acquisition of share, which is the book value on the date of conversion with indexation from the date of conversion, should be computed as a capital gain. In the absence of a specific provision, out of these two formulae, the formula which is favourable to the assessee, should be accepted. We, therefore, of the view that CIT(A) has properly examined this issue in the present situation and directed the AO to accept the capital gain offered by the assessee. We, accordingly, confirm his order. In the result appeals of the Revenue are dismissed.

Issues Involved:

1. Treatment of profit on sale of shares as 'Long-term capital gain' versus 'Business income'.
2. Applicability of Section 45(2) of the Income Tax Act.
3. Methodology for computing gains on conversion of stock-in-trade to investment.

Detailed Analysis:

Issue 1: Treatment of Profit on Sale of Shares

The Revenue challenged the CIT(A)'s decision to treat the profit on sale of shares as 'Long-term capital gain' instead of 'Business income'. The assessee had declared long-term capital gain on the sale of shares, which were converted from stock-in-trade to investment. The AO, however, segregated the income into business income and capital gain, based on the principles laid down in Section 45(2) of the Income Tax Act.

Issue 2: Applicability of Section 45(2) of the Income Tax Act

The AO applied Section 45(2) to compute the income separately as business income till the date of conversion and thereafter as long-term capital gain. The CIT(A) observed that Section 45(2) specifically deals with the conversion of investment into stock-in-trade and not vice versa. Therefore, the CIT(A) concluded that Section 45(2) was not applicable in this case, as it involved conversion from stock-in-trade to investment.

Issue 3: Methodology for Computing Gains

The AO computed the business income as the difference between the book value and market value on the date of conversion and the long-term capital gain as the difference between the market value and the sale price. The CIT(A), however, found this approach arbitrary and unjustified. The CIT(A) directed that the long-term capital gain declared by the assessee should be accepted, as the assessee had converted the shares at book value and held them as investments for a significant period before selling them. The CIT(A) relied on judgments from the cases of Sir Kikabhai Premchand vs. CIT and CIT vs. Dhanuka & Sons to support this decision.

Tribunal's Decision:

The Tribunal upheld the CIT(A)'s decision, agreeing that Section 45(2) does not apply to the conversion of stock-in-trade to investment. The Tribunal noted that in the absence of specific provisions, a rational formula should be applied. Two possible formulas were considered: one used by the AO and another by the assessee. The Tribunal decided that the formula favorable to the assessee should be accepted, which was the difference between the sale price and the book value on the date of conversion, with indexation from the date of conversion. Consequently, the Tribunal confirmed the CIT(A)'s order to treat the gains as long-term capital gains.

Conclusion:

The appeals by the Revenue were dismissed, and the CIT(A)'s decision to treat the gains as long-term capital gains was upheld by the Tribunal. The Tribunal emphasized the absence of specific provisions for such conversions and favored the methodology that benefits the assessee.

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